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Full text of "Tax revision issues, 1976 (H.R. 10612)"

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(H.R. 10612) 



Prepared for the Use of the 



APRIL 26, 1976 








Introduction 1 

1. Tax-exempt status of condominium, cooperative, and homeowner asso- 

ciations 2 

2. Treatment of certain disaster payments 5 

3. Tax treatment of certain 1972 disaster loans 7 

4. Tax treatment of certain debts owed by political parties to accrual basis 

taxpayers 9 

5. Clarification of definition of produced film rents 11 

6. Prepublication expenses 13 

7. Real estate investment trusts — 15 


Digitized by the Internet Archive 
in 2013 


This pamphlet presents background information with respect to a 
series of miscellaneous tax provisions contained in the House-passed 
bill (H.R. 10612). 

In the case of each of the House-passed provisions, the pamphlet 
describes present law, the issues presented and the House-passed pro- 
visions. Other possible miscellaneous provisions will be analyzed for 
the committee in material to be submitted subsequently. 


1. Tax-Exempt Status of Condominium, Cooperative, and Home- 
owner Associations 

Present law 

In developing a real estate subdivision, a condominium project, or 
a cooperative housing project, it is common for developers to form 
owners' associations as an integral part of the overall development. 
Generally, membership in the association is open only to owners of 
lots or dwelling units and is normally required as a condition of owner- 
ship. These associations are formed to allow individual homeowners, 
etc., to act together in managing, maintaining, and improving certain 
areas where they live. The purposes of the organization may include, 
for example, the administration and enforcement of covenants for 
preserving the architectural and general appearance of the develop- 
ment, the ownership and management of common areas such as streets, 
sidewalks, parks, swimming pools, etc., and the exterior maintenance 
and repair of property owned by its members. 

The association is funded by either annual or periodic assessments 
of the members. Generally, there are two categories of assessments 
and expenditures made by the association. First, operating assessments 
are made to administer, manage, maintain, and operate the areas and 
facilities common to all residential units. This includes the mainte- 
nance of parking areas, hallways, elevators, roofs, exterior of build- 
ings, etc. Second, capital assessments are made to build up reserves for 
the replacement of equipment and facilities used in common. This in- 
cludes the equipment and facilities used with respect to swimming 
pools, tennis courts, clubhouse facilities, etc. 

Under present law, generally a homeowners'' association may qualify 
as an organization exempt from federal income tax (under sec. 501 
(c) (4) of the Code) only if it meets three requirements. First, the 
homeowner's association must serve a "community" which bears a rea- 
sonable, recognizable relationship to an area ordinarily identified as a 
governmental subdivision or unit. Second, it must not conduct activi- 
ties directed to the exterior maintenance of any private residence. 
Third, common areas for facilities that the homeowner's association 
owns and maintains must be for the use and enjoyment of the general 

If an association is unable to meet these three requirements, it will 
ordinarily be taxed as a corporation. In general, this means that the 
excess of current receipts over current expenditures at the end of the 
year would be taxable to it, unless the excess is refunded to the mem- 
bers or applied to the subsequent year's assessment. With respect to 
assessments for capital improvements, if the assessments nre desig- 
nated to be used solely for the purpose of making capital improve- 
ments and if the association homeowners have an equity interest in the 
association, the assessments are not current income to the association 


but may be treated as contributions to capital. 1 Also, to the extent that 
the association's accumulated funds earn income, this income is taxable 
to the association. 


Most homeowners' associations have found it difficult to meet the 
three requirements set forth above, and therefore, do not qualify for 
tax exemption. To avoid being taxed on the excess of current receipts 
over current expenditures, a nonexempt association must refund the 
excess to the members or apply the excess to the subsequent year's 

Since homeowners' associations generally allow individual home- 
owners to act together in order to maintain and improve the area in 
which they live, many believe that it is not appropriate to tax the 
revenues of an association of homeowners who act together if an in- 
dividual homeowner acting alone would not be taxed on the same 

House bill 

Under the House bill (sec. 1301), if a qualified cooperative housing 
association so elects it is not to be taxed on any "exempt function 
income". 2 Exempt function income includes membership dues, fees, 
and assessments received from persons who own residential units in 
the particular condominium, subdivision, or cooperative and who are 
members of the association. 

The association is to be taxed, however, on any net income which is 
not exempt function income. For example, an}^ interest earned on 
amounts set aside in a sinking fund for future improvements is tax- 
able. Similarly, any amount paid by persons who are not members of 
the association for use of the association's facilities would be taxable. 
Deductions are to be allowed for expenses directly connected with the 
production of taxable income. The bill provides a $100 deduction 
against taxable income so that associations with only a minimal 
amount of taxable income will not be subject to tax. 

A cooperative housing association is to be taxed as a corporation on 
its taxable income. The tax rate to be applied is the corporate rate 
without the surtax exemption. If the association has net long-term 
capital gain the capital gain portion of the taxable income is normally 
to be taxed at a 30-percent rate. 

Generally, three different types of homeowners associations may 
elect to be treated as tax-exempt cooperative housing associations 
under the bill: Cooperative housing corporations, condominium 
management associations, and residential real estate management 
a ssociations. 

To qualify for this treatment under the House bill, a cooperative 
housing association must meet several requirements. First, the associ- 

1 Rev. Rul. 75-370. 1975-35 I.R.B. 6, indicates that special assessments collected by a 
nnnoxempt condominium management association for replacement of the roof and elevators 
in the condominium are not includible in the association's gross income, and Rev. Rul. 75- 
371, 1975-35 I.R.B. 7. indicates that special assessments collected by such an association 
and accumulated for the replacement of personal property used to maintain common areas 
are contributions to capital. 

2 If the provisions of the bill are not met (or an election is not made to be treated 
as tax-exemDt). a cooperative housing association is to continue to be treated as it is 
presently treated under existing law. 

ation must be organized and operated to provide for the management, 
maintenance, and care of association property. Although the property 
maintained by the association is generally property owned by the as- 
sociation and available for common use by all the members, the associ- 
ation may maintain areas that are privately owned but affect the 
overall appearance and structure of the project . 

Second, a cooperative housing association must meet certain income 
and expenditure tests. 

At least 60 percent of the association's gross income must consist 
solely of membership dues, fees, or assessments from tenant-stock- 
holders, owners of residential units, or owners of residences or resi- 
dential lots, as the case may be. 

Under the expenditure test, at least 90 percent of all of the annual 
expenditures of the cooperative housing association must be to manage, 
maintain, and care for. or improve, association property. Qualifying 
expenditures include both current and capital expenditures on associa- 
tion property. 

In addition to the general requirements, in the case of a condo- 
minium management association, substantially all of the dwelling 
units must be used as residences. Similarly, in the case of a residential 
real estate management association, substantially all the lots or build- 
ings must be used by individuals for residences. In the case of 
a cooperative housing corporation, the corporation must meet the 
special definition for cooperative housing corporations under section 

The House bill would apply to payments received after December 31, 
1073. in taxable years ending after that date. 

2. Treatment of Certain Disaster Payments 

Present la%o 

Under present law (sec. 451(d)), insurance proceeds received by a 
taxpayer as a result of destruction or damage to crops may be in- 
cluded in income in the year following the year of their receipt, if he 
can establish that the income from the crops which were destroyed 
or damaged would otherwise have been properly included in income 
in the following year. 

The provision of present law referred to above was added by the 
Tax Eeform Act of 1969. The purpose of this provision was to avoid 
the doubling up of income for a cash basis farmer by including crop 
insurance proceeds in income in the year they were received rather 
than in the year following the year of receipt, which would generally 
be the pattern of income receipt from sales of crops. 

Because of this doubling up of income in the year of receipt, the 
farmer would have only deductions and no income to report in the next 
year and therefore would be likely to have a net operating loss to carry 
back and offset against income in the prior year. However, the farmer 
in such cases was faced with the payment of tax and subsequent filing 
for a refund. He also would lose the benefit of his personal exemptions 
and his standard or itemized deductions in the year of loss. 


The Agriculture and Consumer Protection Act of 1973 provides 
that specified payments by the Department of Agriculture are to be 
made to farmers in the event that either they are prevented from 
planting crops because of drought, flood, or other natural disaster or, 
because of the disaster, the total quantity of the planted crops which 
are harvested is less than 66% percent of the projected yield of the 
crop. The crops covered by these disaster payments are wheat, corn, 
grain sorghum, barley, and upland cotton. Premium payments are 
not required for this protection. 

The Service has ruled that the provisions of present law referred 
to above do not apply to the pajanents provided to the producers 
covered by the Agriculture and Consumer Protection Act of 1973 since 
the proceeds are not insurance proceeds because no premium was paid 
by the farmer. As a result of the Service's position, these payments 
must be reported as taxable income in the year of receipt and not in 
the year in which the income from the sale of the crops would normally 
be reported. 

House hill 

The House bill (sec. 1302) provides that in the case of a taxpayer 

using the cash receipts and disbursements method of accounting, 

payments received under the Agricultural Act of 1949, as amended by 

the 1973 Act, would be included in the taxable income of the taxpayer, 




at his election, in the year in which the income normally received from 
the crops would have been reported. This provision is to apply only to 
payments received as a result of (1) destruction or damage to crops 
caused by drought, flood or any other natural disaster, or (2) the in- 
ability to plant crops because of a natural disaster. 

The House bill would apply to amounts received after December 31, 
1973 in taxable years ending after that date. 

3. Tax Treatment of Certain 1972 Disaster Loans 

Present law 
Under present law (sec. 165), taxpayers are generally allowed to 
deduct their losses sustained during the taxable year, including losses 
attributable to fire, storm and other casualty, to the extent that the 
losses are not compensated for by insurance or otherwise. 3 In the 
case of any loss attributable to a major disaster which occurred in 
an area authorized by the President to receive disaster relief, a special 
rule allows the loss, at the election of the taxpayer, to be deducted 
on the return for the year immediately before the year of the dis- 
aster (that is, the loss may be deducted on the return generally filed in 
the year the disaster occurs). Where a deduction resulting from a loss 
is claimed in one year, and compensation is paid for the loss in a later 
year, the compensation is generally required to be taken into income by 
the taxpayer in the later year. 

In some cases individuals were hard hit by disasters, such as flood, 
and claimed a deduction with respect to the disasters, unaware, in 
many cases, that they might later receive compensation, or partial 
compensation, for their loss. In some instances, the compensation 
may be received in a year for which the taxpayer is in a higher tax 
bracket than he was in for the year for which the disaster loss deduc- 
tion was claimed. As a result, the taxpayer may be required to pay 
more tax, with respect to the compensation or reimbursement, than 
would have been owing if he had not claimed the deduction in the 
first place. 

House hill 
Under the House bill (sec. 1303), a taxpayer who received income 
in the form of a cancellation of a disaster loan, or in the form of com- 
pensation in settlement of a tort claim with respect to certain disaster 
losses sustained in 1972 which were determined by the President to 
warrant disaster assistance, would be accorded special tax treatment 
if the cancellation or tort settlement does not exceed $5,000. The tax 
on the first $5,000 of compensation received in this type of case is not 
to exceed the tax which would have been payable if the $5,000 (or 
lesser) deduction had not been claimed. This treatment applies only 
if the taxpayer elects to come under these provisions. The $5,000 
amount would be reduced by $1 for each $1 of the taxpayer's adjusted 
gross income over $15,000 ($7,500 in the case of a married taxpayer 
riling a separate return) for the year in which the deduction for the 
loss was taken. 

8 Individuals generally are allowed to deduct their losses of property (not connected 
with their trade or business) only to the extent that the loss exceeds S100 : losses attrib- 
utable to an individual's business are fully deductible. 



The election may be made for up to $5,000 of compensation paid in 
a year after the year for which the loss deduction is claimed and which 
results either (1) from the forgiveness or cancellation of a disaster 
loan under section 7 of the Small Business Act or an emergency loan 
under subtitle C of the Consolidated Farm and Rural Development 
Act, or (2) from a payment made to the taxpayer in settlement of a 
tort claim which the taxpayer had against another person. 

Any compensation or reimbursement in excess of the $5,000 limita- 
tion must be taken into income by the taxpayer for the year in which 
the payment is received. 

The House bill also provides that any tax wdth respect to this $5,000 
(or lesser) amount still unpaid on October 1, 1975, may be paid in three 
equal annual installments, with the first installment payable on 
April 16, 1976. Also, no interest on any deficiency with respect to this 
$5,000 amount is to be payable for any period prior to April 15, 1976, 
and no interest is to be payable on any installment payment before the 
due date for that installment. 



4. Tax Treatment of Certain Debts Owed by Political Parties to 
Accrual Basis Taxpayers 
Present law 

Under present lav/ (sec. 271), any deduction generally allowable 
for bad debts or for worthless securities is not allowed for a worth- 
less debt owed by a political party. This rule applies to all taxpayers 
other than a bank, but, where the debt arises out of the sale of goods 
or services, the rule in practice affects only taxpayers utilizing the 
accrual method of accounting (because only these taxpayers would 
have taken into income the receipts which give rise to the debt) . 

Present law for this purpose defines political parties to include all 
committees of a political party and all committees, associations, or 
other organizations which accept contributions or make expenditures 
on behalf of any individual in any Federal, State or local election. 


It has been pointed out that the disallowance of a bad debt deduc- 
tion for debts owed by political parties means that taxpayers who 
are in the business of providing goods or services (such as polling, 
media, or organizational services) to political campaigns and candi- 
dates are treated less favorably than taxpayers in virtually any other 
business because they are not able to deduct bad debts which arise 
in the ordinary course of their business. 

It is noted that this provision disallowing any bad debt deduction 
was originally enacted to prevent tax deductions for concealed con- 
tributions. However, it is argued that since, in the case of the sale 
of goods or services, the deduction is allowed only if the amount 
of gross receipts which gave rise to the debt has been included in 
taxable income, the effect o,f the provision is to tax these individuals 
on income which they have never received. 

Furthermore, since present law does not affect cash basis taxpayers 
who sell services for political campaigns (because in that case no 
amount is taken into income), it is suggested that the provision dis- 
criminates against taxpayers whose business differs from others only 
in that they are on the accrual method of accounting. 

House bill 
The House bill (sec. 1304) adds an exception to the provision dis- 
allowing a deduction for bad debts owed by political parties. The 
exception applies only to taxpayers who use the accrual method of 
accounting. These taxpayers are to be allowed a bad debt deduction 
with respect to debts which are accrued as a receivable in a bona fide 
sale of goods or services in the ordinary course of their trade or busi- 
ness. The bill limits this exception to those cases in which 30 percent of 
all of the receivables accrued in the ordinary course of all of the trades 



or businesses of the taxpayer are due from political parties. Also, the 
bad debt deduction is to be allowed only if the taxpayer has made 
substantial continuing efforts to collect on the debt. 

Under the House bill, this provision applies to taxable years begin- 
ning on or after January 1, 1975. It also applies to taxable years be- 
ginning before January 1, 1975, for which the assessment of a defi- 
ciency, or the making of a refund, or the allowance of a refund or credit 
of any overpayment, is not barred on the date of enactment of this 

5. Clarification of Definition of Produced Film Rents 

Present law 

Under present law, a corporation which is a personal holding com- 
pany is taxed on its undistributed personal holding company income 
at a rate of 70 percent. A corporation may be a personal holding 
company where five or fewer individuals own 50 percent or more in 
value of its outstanding stock and where at least 60 percent of the 
corporation's adjusted ordinary gross income comes from specified 
types of passive income. 

One income category treated as personal holding company income is 
"produced film rents." Generally, this category covers payments re- 
ceived by the corporation from the distribution and exhibition of 
motion picture films if these rents arise from an "interest" in the film 
acquired before its production was substantially completed. Produced 
film rents are not treated as personal holding company income, how- 
ever, if such rents constitute 50 percent or more of the corporation's 
ordinary gross income. The qualifying rental interest under this cate- 
gory is one which arises from participation in the production of the 

Payments received from the use of, or right to use, a film are treated 
as copyright royalty income, if the corporation's interest in the film 
is acquired after production was substantially completed. 

Amounts received under a contract under which the corporation 
is to furnish personal services may also be classified as personal hold- 
ing company income. 


A question concerning the proper definition of produced film rents, 
for purposes of the personal holding company rules, has resulted from 
a recent decision by the Tax Court 4 which denied depreciation deduc- 
tions to an independent production company which produced an 
original motion picture with nonrecourse financing supplied by a 
major studio-distributor under an agreement that, on completion, all 
rights to the picture except a share in distribution profits vested in the 
distributor. The court held that, in these circumstances, the produc- 
tion company had no ownership interest in the film after it was com- 
pleted and therefore could not depreciate the costs of producing film. 

Although this case involved depreciation rather than personal hold- 
ing company issues, it appears that the Internal Revenue Service has 
interpreted 'the decision to require that an "interest" in a film, for 
purposes of the definition of produced film rents in sec. 543(a) (5), 
must be a depreciable interest. If a production company has only a 
profit participation after the picture is completed and released, but 
legally does not have an ownership interest sufficient to claim deprecia- 

4 Carnegie Productions, Inc., 59 T.C. 642 (1973). 



tion, some revenue agents have treated all of the company's income as 
personal service contract income (under sec. 543(a)(7) of present 

The issue is whether this treatment is appropriate, for personal 
holding company purposes, or whether a production company's right 
to participate in income or profits should be treated as produced film 
rents (thus helping the corporation to escape personal holding com- 
pany status if the rents exceed 50 percent of the corporation's ordi- 
nary gross income), if this income arises from bona fide production 
activities in the making of the film (regardless of whether the profits 
interest is depreciable). 

House bill 

Under the House bill (sec. 1305), in the case of a producer who -ac- 
tively participates in the production of a film, the term "produced film 
rents*' for purposes of personal holding company income would in- 
clude an interest in the proceeds or profits from the film, but only to 
the extent such interest is attributable to such active participation*. 

This provision would apply to taxable years ending on or after 
December 31, 1975. 

6. Prepublication Expenses 

Present law 

Present law (sec. 174(a) (1) ) permits, under certain circumstances, 
a deduction for research and experimental expenditures otherwise 
chargeable to a taxpayers capital account. The regulations under this 
provision define research and experimental expenditures as expendi- 
tures incurred in connection with a taxpayer's trade or business which 
represent research and development costs in the experimental or lab- 
oratory sense. Specifically excluded are expenditures for research in 
connection with literary, historical, or similar projects. 

In Rev. Rul. 73-395,* the Internal Revenue Service held that the 
costs incurred by an accrual basis taxpayer in the writing, editing, de- 
sign and art work directly attributable to the development of text- 
books and visual aids do not constitute research and experimental ex- 
penditures under section 174. The Service further held that these costs 
cannot be inventoried (under sec. 471) but instead represent expendi- 
tures that must be capitalized (under sec. 263) and may be depreciated 
(under sec. 167(a) ). 

However, the ruling also stated that expenditures incurred in the 
actual printing and publishing of textbooks and visual aids should 
be inventoried (under sec. 471) with a part of the costs beino- appor- 
tioned to the books and visual aids still on hand at the end of the tax- 
able year. Also, expenditures for manuscripts and visual aids that are 
abandoned may be deductible as losses (under sec. 1*65). 

In addition, the Service anounced (in Rev. Rul. 73-395) that it 
would not follow the decision of the United States District Court, 
Central District, California, in Stern v. United States, 6 which held 
that a taxpayer, in the business of writing books, could deduct travel- 
ing expenses incurred while researching, writing and arranging ma- 
terial for a book. 7 

On March 17, 1976, the Internal Revenue Service announced 8 that 
it has begun a study project as a result of questions regarding the 
application of Rev. Rul. 73-395 to certain prepublication expenses 
of the publishing industry. The Service will study the application 
of sections 162 (dealing with the deduction of trade or business ex- 
penses), 263 (treatment of capital expenditures), and 471 (general 
rule for inventories) to prepublication costs within different segments 
of the industry. 

5 1973-2 C.B. 87. 

6 1071-1, U.S.T.C. 9375. The case involved two issues : (1) whether the taxpayer was 
engaged in the business of writing, and ('2) whether traveling expenses were deductible as 
ordinary and necessary business expenses or constituted non-deductible expenditures for 
the improvement of a capital asset. 

7 The Government said that it did not appeal the case because it had erroneously stipu- 
lated to the effect that "if the taxpayer was determined to be in the business of bein<r a 
writer, the traveling expenses in question were ordinary and necessary." 

8 Press Release IR-1575. 



The Service stated that the application of these sections is not 
adequately explained in Eev. Eul. 73-395, and that the project is 
expected to result in the publication of regulations and/or additional 
revenue rulings. It is also likely that Kev. Eul. 73-395 will be modified 
and clarified or superseded. 

Pending completion of this project, the Service is suspending audit 
and appellate activity with respect to cases in which the deductibility 
of these prepublication expenses is an issue. No further action will 
be taken in these cases except as necessary to protect the interest of 
the Government. 

The announcement did not indicate whether the Service, as part 
of the project, will reconsider its determination not to follow the 
Stem decision. 


The treatment of prepublication expenditures involves two general 
issues: first, whether it is desirable to require the capitalization of 
prepublication expenses; and second, the correct application of the 
Internal Eeveue Code to those expenses. 

The interpretative issue arises because historically industry mem- 
bers claim that they generally have deducted prepublication expenses 
currently and that until the publication of Eev. Eul. 73-395 the 
Service has seldom questioned this practice. Eev. Eul. 73-395 gen- 
erally requires capitalization. 

Eev. Eul. 73-395 also affects writers. Taxpayers in the business 
of writing claim that prepublication expenditures are trade or busi- 
ness expenses which are currently deductible (under sec. 162), as 
the Stern case held, and do not constitute capital expenditures. 

House hill 

The House bill was passed before the Service announced its study 
project on the tax treatment of prepublication of expenditures and 
Eev. Eul. 73-395. 

The bill (sec. 1306) allows taxpayers to treat their prepublication 
expenditures in the manner in which they have been applied consist- 
ently by the taxpayer in the past until new regulations are issued with 
regard to these expenditures after the date of enactment of the bill. 

Any regulations issued by the Internal Eevenue Service would apply 
only to taxable years beginning after their issuance. Until these regu- 
lations are issued, the Internal Eevenue Service would administer 
the application of sections 162. 174 and 263 to publishers' prepublica- 
tion expenditures without regard to Eev. Eul. 73-395. In addition, as 
indicated above, the Service would administer these sections in the 
same manner as they were consistently applied by taxpayers prior to 
the issuance of Eev. Eul. 73-395. If a taxpayer did not consistently 
follow a specific tax accounting method, his returns would be treated 
by the Service in accord with usual administrative procedures. 

' The prepublication expenditures affected by the House bill are those 
paid or incurred in connection with the taxpayer's trade ot business of 
publishing f or the writing, editing, compiling, illustrating, designing 
or other development or improvement of a book, teaching aid, or 
similar product. 

7. Real Estate Investment Trusts 

Present law 

Under present law, real estate investment trusts ("REITs") are 
provided with the same general conduit treatment that is applied to 
mutual funds. Therefore, if a trust meets the qualifications for REIT 
status, the income of the REIT which is distributed to its owners 
each year generally is taxed to them without being subjected to a tax 
at the REIT level (the REIT being subject to tax only on the income 
which it retains and on certain income from property which qualifies 
as foreclosure property). Thus, the REIT provides a means whereby 
numerous small investors can im^est in real estate assets under pro- 
fessional management and allows them to spread the risk of loss by 
the greater diversification of investment which can be secured through 
the means of collectively financing projects which the investors could 
not undertake individually. 

In order to qualify for conduit treatment, a REIT must so elect 
and must satisfy four tests on a year-by-year basis; organizational 
structure, source of income, nature of assets, and distribution of in- 
come. These conditions are intended to allow the special tax treatment 
for a REIT only if there really is a pooling of investments which is 
evidenced by its organizational structure, if its investments are basi- 
cally in the real estate field, and if its income is clearly passive income 
from real estate investment, as contrasted with income from the 
operation of business involving real estate. In addition, substantially 
all of the income of the REIT must be passed through to its share- 
holders on a current basis. 

With respect to the organizational structure, a REIT, in general, 
must be an unincorporated trust or association (which would be tax- 
able as a corporation but for the REIT provisions) managed by one 
or more trustees, the beneficial ownership of which is evidenced by 
transferable shares or certificates of ownership held by 100 or more 
persons, and which would not be a personal holding company even 
if all its adjusted gross income constituted personal holding company 

With respect to the income requirements, at least 75 percent of the 
income of the REIT must be from rents from real property, interest 
on obligations secured by real property, gain from the sale or other 
disposition of real property (or interests therein, including mort- 
gages), distributions from other REITs, and abatements or refunds 
of taxes on real property and income and gain derived from property 
which qualifies as foreclosure property. An additional 15 percent of 
REIT income must come from these sources, or from other interest, 
dividends, or gains from the sale of securities. Income from the sale or 



other disposition of stock or securities held less than 6 months, or real 
property held less than 4 years (except in the case of involuntary con- 
versions) must be less than 30 percent of the REIT's income. 

With respect to the asset requirements, a REIT must have at least 
75 percent of the value of its assets in real estate, cash and cash items, 
and Government securities. However, not more than 5 percent of the 
assets can be in securities of any one nongovernment, non-REIT issuer, 
and these holdings may not exceed 10 percent of the outstanding voting 
securities of such issuer. Also, no property of the EEIT other than 
foreclosure property, may be held primarily for sale to customers. 

In addition, a REIT is required to distribute at least 90 percent of 
its income (other than capital gains income and certain net income 
from foreclosure property, less the tax imposed on such income by 
section 857) to its shareholders during the taxable year, or declare 
it as a dividend by the due date for filing its tax return for the year 
(including any extension) and pay the dividend within 12 months 
from the close of the taxable year. 

If all of these conditions are met, then the REIT generally is quali- 
fied for the special conduit treatment which allows the income that is 
distributed to the shareholders to be taxed to them without being sub- 
jected to a tax at the trust level, so that the REIT is only taxed on the 
undistributed income and certain income from foreclosure property. 
Otherwise, a trust that does not meet the requirements for qualifica- 
tion as a REIT would be treated as a corporation, in which case all of 
its income would be taxed to the REIT, not just the undistributed 


Although the provisions have been amended from time to time, until 
1974 the basic rules with respect to REITs have remained the same 
since their enactment in 1960. (In 1974. the Congress dealt with the 
difficulty a REIT may have in meeting the income and asset tests if 
it must foreclose on a mortgage that it owns or reacquire property 
which it owns and has leased). Since 1960, the REIT industry has 
grown enormously in size and is responsible for a large portion of the 
investment in the real estate field in the United States today. How- 
ever, industry representatives have stated that problems have arisen 
with respect to the REIT provisions which could significantly affect 
the indstry if they are not modified. 

These problems relate to the fact that under present law if a REIT 
does not meet the various income, asset, and distribution tests. The 
REIT will be disqualified from using the special tax provisions even 
in cases where the failure to meet a requirement occurred after -a good 
faith, reasonable effort on the part of the REIT to comply. Disquali- 
fication would have the effect of not only changing the tax status of 
the REIT itself, subjecting its income to tax at corporate rates, but 
also could adversely affect the interests of the public shareholders of 
the REIT. Questions have been raised as to whether it is appropriate 
to disqualify a REIT in such circumstances. 


House hill 
In general, the House bill (sees. 1601-1606) makes the following 
changes with respect to the provisions of the tax law relating to 

(1) As discussed above, under present law. a REIT generally is 
required to distribute 90 percent of its taxable income each year to its 
shareholders. If it does not meet this requirement, the trust will be 
disqualified as a REIT and thus must pay tax on its income as if it 
were a regular corporation. Under the House bill, a REIT will not be 
disqualified if it is determined, on audit, that the failure to meet the 
90-percent distribution requirement was due to reasonable cause. In this 
case, the REIT is to be allowed to distribute deficiency dividends to 
its shareholders to avoid disqualification. However, interest and penal- 
ties are to be imposed on the amount of the adjustment under this 

(2) Under present law certain percentages of a REIT's income must 
be derived from designated sources. The House bill provides that if a 
REIT were found to have failed to meet the income source tests, it 
would not be disqualified, but would be allowed to pay tax on the 
amount by which it failed to meet the income source tests. This provi- 
sion would be available only if the REIT initially had reasonable 
ground to believe that it had met the income source tests. 

(3) Present law prohibits a REIT from holding property (other 
than foreclosure property) for sale to customers. The House bill 
eliminates the "holding'' prohibition and substitutes a limit on the 
amount of income a REIT can derive from property so held. Under 
the House bill, a REIT could have a ale minimis amount (up to one 
percent) of its gross income from such sources, and this income would 
be subject to corporate tax. Any income from such sources in excess 
of one percent would be subject to an additional tax under the provi- 
sions discussed above, but would not disqualify the REIT, provided 
the REIT had reasonable grounds to believe that the excess income 
was not holding- for-sale income. 

(4) The House bill also provides that certain types of income that 
customarily are earned in a real estate business but which do not now 
qualify under the income source tests are to be treated as qualifying 
income. These include (a) certain rents from personal property leased 
together with the real property; (b) charges for services customarily 
furnished in connection with the rental of real property whether or 
not such charges are separately stated; and (c) commitment fees re- 
ceived for entering into agreements to make loans secured by real 

(o) The income source requirements are increased by the House 
bill so that at least 95 percent of the REIT's income must be from 
passive sources. Also, all income, other than passive income, would be 
subject to corporate tax. 

(6) Under the House bill, a REIT would be permitted to operate in 
corporate form ; under present law, a REIT must operate as a trust 
or association. 


(7) Under the House bill, a REIT would be required to designate 
the year to which a dividend payment relates. (Under present law. 
a dividend may relate either to the year in which it is paid, or the 
immediately preceding year in most cases.) Also, a REIT is to be 
subject to a 3 percent charge on the amount by which it fails to dis- 
tribute at least 75 percent of its income in the year received. In addi- 
tion, a new REIT would be required to be on a calander year for tax 

(8) Certain other changes are made concerning technical rules ap- 
plicable to REIT's, including changes in the rules regarding income 
from sale of mortgages held for less than four years, and regarding 
options to purchase real property. 

Under the House bill, the provisions outlined above would apply 
generally to taxable years of real estate investment trusts beginning 
after the date of enactment. 



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